The difference between RBI and US Fed puts additonal constraint on the former

Over the next few days, two central banks will announce their policy stance.

The Reserve Bank of India (RBI) will announce its decision on Wednesday, after its Monetary Policy Committee (MPC) concludes its two-day meeting. The US Federal Reserve will announce its decision exactly a week later, after the Federal Open Markets Committee concludes its two-day deliberations. Both will be keenly watched.

But there the similarity ends. RBI must contend with an economy growing below potential. Latest numbers released by the Central Statistical Organisation (CSO) show the economy slowing. Though growth in GDP in 2016-17 was a respectable 7.1 per cent, gross value added during January-March 2017 was a dismal 5.6 per cent, the lowest in the past 16 quarters, barring the fourth quarter of 2013-14. Worse, the ratio of gross fixed capital formation to GDP, a measure of investment, has fallen to 28.5 per cent, the lowest in 16 quarters.

Juxtapose the inflation rate (barely 3 per cent in April 2017) vis-à-vis RBI’s target of 5 per cent for Q4, 2016-17 or its repo rate (6.25 per cent), with the dismal investment rate and the case for a reduction in interest rates seems self-evident.

A real repo rate of 3.25 per cent (taking actual inflation as a proxy for inflation expectations) is not only well above RBI’s stated objective of keeping real interest rates in the range of 1.5-2 per cent, it is more likely than not to discourage investment.

Surplus LiquidityBut it would be simplistic to see this as a cast-iron case for a repo rate cut. Not only is there no one-to-one relationship between interest rates and investment, demonetisation has already done what a rate cut could hope to achieve. Indeed, it has done what repeated signals from RBI have failed to do. Add to this the fact that the US Fed is poised to raise rates at least once, if not twice, this year, liquidity is still surplus, there are signs of asset price bubbles in some asset markets, and the case for a rate cut becomes much weaker.

The Fed is at the other end of the spectrum. First quarter GDP growth has been revised upwards from 0.7 per cent to 1.2 per cent. Unemployment at 4.4 per cent is at a decadal low and inflation is close to the Fed’s target of 2 per cent.

After the quarter percentage hike in interest rates in March 2017, the Fed is on course to raise rates by another quarter percent at its meeting next week. In all likelihood, this will be followed by another in September, in line with the Fed’s projection of three rate hikes in 2017.

Central bank governors, the world over, like to say (believe?) they frame monetary policy keeping the domestic situation in mind. The reality is quite different.

“Monetary policy in India is solely conducted with domestic objectives in mind and our decision to change the policy repo rate, if and when taken, will be on the basis of growth-inflation dynamics in our country,” said Urjit Patel, responding to an earlier question on how Fed policy would impact India.

DynamicsBy that logic, the current domestic growth-inflation dynamics would seem to support a rate cut. But here’s the catch. When the Fed is on a tightening cycle, few central banks can afford to cut rates. Not without risking capital outflow. The freedom to fashion policy, divorced from the Fed, is further constrained when overseas capital flows play an important role in macroeconomic stability, as in India.

Hence, despite governor Patel’s bravado about being guided solely by domestic factors, the MPC will have to keep in mind the possible consequences of Fed action. Lending rates are already quite low. If investment is not happening, it is for other reasons. Arepo rate cut by RBI on Wednesday is unlikely to reduce lending rates further or stimulate investment.

It could, at best, bring policy rates in consonance with the market, but at the risk of aggravating asset price bubbles and reigniting nascent inflationary pressures that are never very far from the surface in India.

Agreed, under Patel, RBI has consistently over-estimated upside risks to inflation (see chart). But that is inevitable in a monetary policy framework that gives precedence to inflation targeting over growth. The truth, however unpalatable it might be to politicians looking for quick fixes — and regardless of farfrom-subtle hints from government officials — is that no purpose will be served by cutting interest rates today.

Apart from the limited objective of aligning policy rates with the market to make RBI appear technically correct. A rate cut alone will not rid the economy of the pain vested by demonetization. The answer to lower growth lies elsewhere.

“An economist,” said former US president Ronald Reagan, “is someone who sees something that works in practice and wonders whether it would work in theory.”

It would be tragic if the MPC, constituted solely of economists, were to prove him right and opt to cut rates to uphold its academic credentials (and, maybe, satisfy government). There is no other case to cut.